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Taking Measure of Two Bond Giants

A visit to PIMCO and Western Asset Management elicited interesting findings.

Lawrence Jones, 02/17/2009

As part of the due diligence Morningstar fund analysts perform on the funds and fund families we cover, we regularly visit fund companies. In mid-January, a few colleagues and I flew out to Los Angeles to visit two of the largest players in the fixed-income marketplace: PIMCO (which had nearly $750 billion in assets under management at the end of 2008, including $132 billion PIMCO Total Return PTTRX) and Western Asset Management ($586 billion in assets, including funds in its own name, and those it runs for parent Legg Mason). The meetings we had at the two firms proved to be a study in contrasts, and in some respects this was underscored by how each firm fared in 2008's brutal market for bonds.

Take It From the Top: A Snapshot of Organizational Change
Both PIMCO and Western have seen significant changes at the top of their organizational structures, but for different reasons. In PIMCO's case, back in 2007, the firm's leadership anticipated the need to provide strong and credible succession planning for both then CEO Bill Thompson and for CIO Bill Gross. In an unconventional move, the firm hired former managing director and senior portfolio manager Mohamed El-Erian, then president and CEO of Harvard Management Company to serve in the new combined position of Co-CEO and Co-CIO beginning January 2008.

El-Erian had taken over as head of Harvard Management in February 2006, after working at PIMCO for seven years. During his short tenure there he rebuilt the university's endowment investment staff, which had suffered when former head Jack Meyer left to found hedge fund Convexity Capital, taking 33 investment professionals with him. El-Erian's return to PIMCO was clearly positive for the firm, as in addition to being widely considered one of the leading investment minds around, his academic and governmental experience made him well-qualified for the new role. Thus, in September 2008, when Thompson announced his retirement at the end of that year, we already knew PIMCO was in good hands.

Western's situation was different, in part due to the circumstances surrounding the change of its chief investment officer in late summer 2008. In August 2008 Western's longtime (and highly respected) CIO, Ken Leech, stepped down from heading the firm for medical reasons, and he was replaced by then deputy-CIO Steve Walsh. At that time, Leech and Walsh had served in these positions since 1990 and 1991, respectively, so the change did impact a longstanding leadership structure. Moreover, while Leech has still been able to take part in the investment discussion from his new position as emeritus CIO, his full presence as head of the firm is still clearly missed by many. Also, Western has yet to name Walsh's deputy, and these changes at the top take place in the context of broader organizational change at the firm.PAGEBREAK

One example of this organizational change came at the end of 2005, when Legg Mason swapped its brokerage unit for Citigroup Asset Management, which added $400 billion in assets under management to the firm, many former Salomon Brothers and Smith Barney legacy funds, and a slew of investment personnel. Western initially decided to retain all the Citigroup managers to allow for some continuity during the acquisition's integration; however, by late 2007 the firm saw some overlap in investment personnel resulting from the acquisition and eliminated eight portfolio managers and analysts from their New York office, in addition to several other departures that occurred since the acquisition.

This is not to suggest that manager turnover has been absent at PIMCO, but with the exception of a few high-profile departures in recent years, such as TIPS manager John Brynjolfsson, global bond manager Sudi Mariappa, and high-yield manager Ray Kennedy, we've seen good stability among the investment personnel there. In the end, while the circumstances surrounding the CIO changes at PIMCO and Western were very different, PIMCO appears to have been better set up organizationally to weather 2008's storms. For Western's Walsh, August 2008 (roughly a month prior to the Lehman Brother's implosion, which would touch off the worst quarter ever for many fixed-income sectors) was an unfortunate time to take on his new role. Clearly, tackling organizational changes in the midst of financial market meltdown is less than ideal.

The View from 30,000 Feet
One very significant difference between PIMCO and Western heading into 2008 was the macroeconomic outlook predominant at each firm, which of course would have profound investment performance implications during the financial crisis. Western's outlook in mid-2007 (when the crisis was still in its early stages) is perhaps best captured by an uncomfortable exchange between Walsh and FPA New Income FPNIX manager Bob Rodriguez during the fixed-income panel of the Morningstar Investment Conference that year. The issue at hand was whether taking on credit risk was appropriate at the time, given that many credit sector yields were close to historically narrow ranges relative to comparable maturity Treasuries, indicating to Rodriguez that these parts of the market offered little value for their risks. Walsh disagreed, arguing that Western was still finding some good opportunities in the credit markets at that time.PAGEBREAK

And in fact, Walsh later admitted that Western's two greatest errors heading into 2008 were adding to credit sectors too early, as prices declined and yield spreads widened, and adding to subprime-exposed non-agency mortgage securities to the extent the firm did. This latter move was particularly painful, as related by structured products team leader Ronald Mass, as the firm was well aware of the increasing trouble in the subprime mortgage space but thought that it was protected by purchasing the highest-quality securities in that sector, which seemed to be offering good value. Of course, fears over rising delinquencies, expected defaults, and losses, in the wake of a dramatic nation-wide housing price collapse, would soon overshadow the protection these securities appeared to offer and their prices declined too.

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